Fed stress tests: Banks come out stronger than ever

March 21, 2014, 12:24 AM UTC

FORTUNE — The nation’s largest banks passed the Federal Reserve’s stress test with their best grade ever.

Of the 30 banks tested by the Fed, 29 were deemed strong enough to weather a severe economic meltdown without any assistance from the government. Collectively the banks cleared the test by a wider margin than a year ago. And the banks didn’t just have more capital — the amount of money they have in reserve to cover losses — than a year ago. The Fed also projected they would have fewer bad loans and fewer trading losses.

The results are a big boon for the banks, the majority of which are hoping to gain approval from regulators to significantly increase the amount of dividends they pay their shareholders, and how much money they spend buying back stock. Regulators have kept tight reins on both of those activities since the financial crisis, because they can drain the banks capital.

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Not that there wouldn’t be some problems. Zions Bancorp (ZION), a regional lender based in Salt Lake City, would sustain big enough losses to potentially put it in jeopardy in the Fed’s dire scenario. All told, the Federal Reserve estimated that these firms would lose just over $500 billion dollars if the economy were to enter another recession similar to the one we just had. That’s up from the $466 billion in bank losses the Fed projected a year ago. This year’s test, though, included 30 banks, up from 18 a year ago.

Among the nation’s biggest lenders, Bank of America (BAC) came out looking the weakest. A key ratio the Fed looks at to measure financial strength was projected to drop to the lowest level (among all banks tested) at BofA. Still, the bank would have to have an additional $13 billion in losses above the $78 billion that the Fed projected in the test for it to run into trouble. That represents a drop in the pecking order for BofA, which came out toward the top of the heap in last year’s test results.

Wells Fargo (JPM) got the best news among the big banks. It came out of the test with the highest grade. That was a big boost from a year ago, when the bank’s own projected losses were much lower than what the Fed projected, catching bank’s executives off guard. This year’s test also showed a big improvement for Goldman Sachs (GS). It jumped to No. 2 among the nation’s biggest banks. Last year, it came out of the stress test at the bottom of the pack. It was also asked to resubmit its capital plan.

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JPMorgan Chase , again, had relatively disappointing results in the Fed’s stress test, coming out only slightly above Morgan Stanley (MS) and BofA on the Fed’s key metric of financial strength. It also was projected, like last year, to have the biggest losses of the 30 biggest banks, at just over $81 billion. That was up $4 billion from a year ago.

The Fed conducted its stress test by looking at how much the banks could stand to lose in their loan portfolios and trading books under an adverse economic scenario. The scenario included a rise in the unemployment rate to 11.3%, a 50% drop in the Dow Jones industrial average, and a 26% drop in housing prices.

After estimating those losses, the Fed then figured how much capital a bank would have left as a percentage of its remaining loans and investments, weighted for risk. The Fed generally deems a bank healthy if it has enough capital to cover a 5% drop in its assets. At the worst of the financial crisis, the average so-called capital ratio at the largest banks dropped to 5.6%. But the Fed said the average capital ratios of the big banks would only dip to 7.6% in this year’s stress test. That was up from 7.4% a year ago.

For the first time this year, the Fed also included how the banks would fare under a slightly less severe, but still difficult economic scenario. That one included a milder recession, but a jump in interest rates and inflation, something not included in the more severe test. In that scenario, the banks came out looking even better, with the average capital ratio at its worst dropping to around 10%.

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Of course, those results will probably lead some to say the test was too easy. Despite nearly the same economic assumptions, the Fed estimated that only 6.9% of all loans would go unpaid. That’s down from 7.5% a year ago. Fed officials said it appeared the banks had increased the quality of their loans.

Another example: For the first time, the Fed had the biggest banks factor into their results how much they could lose if their largest trading partner were to go under. Despite the added hurdle, Goldman’s projected trading losses dropped by $5 billion from a year ago. Of course, that could be what Goldman stands to benefit from getting the best of its largest trading partner.

What’s more, some observers have noticed that banks seem to be holding onto some assets just because they look good to regulators. “The banks’ balance sheets are being manufactured in a way that will make them look good under the rules, even if some of those assets don’t make you the most money,” says Dan Ryan, a partner at PriceWaterhouseCoopers who heads up the firm’s financial services regulatory advisory practice. “It’s been a balance between shareholders and regulators, and right now regulators are winning.”

The release of the results is only the beginning. Next week, the Fed will announce whether or not to approve plans by big banks to increase dividends and buy back more stock.